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A Dysfunctional Credit Market

By Floyd Norris March 3, 2008 2:29 pmMarch 3, 2008 2:29 pm

The Bank for International Settlements — the central banks’ central bank, as it is known — is out today with its quarterly review. For a normally reserved institution, it is blunt is discussing what is wrong with the credit market. Here’s an excerpt, with italics added by me for emphasis:

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“One catalyst for the renewed credit market weakness was continued uncertainty about the ability of the financial system to provide and allocate credit. Parts of the credit market remained largely dysfunctional, with asset-backed issuance volumes down, high-yield bond markets effectively closed, and large backlogs of leveraged loan deals still awaiting financing. Against this background, bank balance sheets continued to be under pressure and financial sector spreads saw renewed widening from mid-January, adding to perceptions of systemic risk.”

The two largest independent mortgage lenders before the collapse are now both struggling. Countrywide Financial is still operating thanks largely to Bank of America, which plans to acquire it. (But the deal spread — the difference between Countrywide’s share price and the value of the BAC shares that are supposed to be exchanged for it — is edging up. A week ago, it was 11 percent. As I write this, it is up to 13.9 percent.) There is a stunning disclosure in its annual report, reported in The Wall Street Journal today, which I will get to in a moment.

Thornburg Mortgage could use an acquirer. On Friday it disclosed that it had faced margin calls, and then disclosed today that it cannot meet a new round of such calls.

Thornburg President Larry Goldstone puts the blame of those stupid accountants, who “are forcing companies to take unrealized write-downs on assets they have no intention of selling.” But the immediate problem is that lenders who put up money to buy those assets want to be protected just in case the declining market values turn out to be real. That is what can happen when your basic business strategy calls for you to borrow in the short-term market and lend in the long-term market.

I talked about Thornburg a bit — although I did not know of today’s announcement — on CNBC today. Most of the conversation was about my “Off the Charts” column from Saturday, in which I discussed the rising tide of foreclosures.

Countrywide filed its annual report Friday. The disclosure, highlighted by The Journal today, concerns home equity lines of credit.

Put as simply as I can, Countrywide sold these lines of credit through securitizations. When homeowners borrow more from such lines, the securitization trusts are supposed to put up the cash. If the homeowners pay the lines down, the securitizations get the money. Here’s the catch. If things get bad enough, the securitizations don’t have to put up the cash, and Countrywide has to come up with the money some other way. It will get repaid only after all the securization holders are satisfied. It recorded a loss of $704 million, but says the potential loss is much greater:

“The available credit lines for the securitizations subject to or expected to be subject to a future draw obligation are approximately $2.4 billion at Dec. 31, 2007. However, due to the borrower’s ability to pay down and redraw balances, a maximum obligation cannot be defined.”

According to The Journal, Countrywide did not factor in that possibility in its computer models that calculated its possible exposures. Did B of A understand it when they agreed to the deal? I left a message for a bank spokesman asking that question, and will let you know if I get an answer.

Update at 3:45 p.m.

Scott Silvestr, a spokesman for the Bank of America, called back, and did not answer the question. “We did extensive due diligence before buying the company and in our financial models we included significant losses beyond those already reported,”
he said. But he did not say if the models took into account losses from this particular issue.

In addition to the idea that fear makes borrowing short term to invest long term break down, there is a more primary fundamental thing happening right now.

It’s widely thought by very informed experts that house prices will continue to decline at least 15% nationally, and reasonably likely to be more than 15%. This makes such investments *very* risky, and thus it is more reasonable to use Occam’s razor and think of the problem from this straightforward angle.

If you try to be objective, and simply average all the diverse expert opinions by the most experienced, you’ll get a big number for the expected decline.

It’s obvious to then expect a lot more defaults. This is also why banks want to sell mortgages to FHA soon, before the price declines become apparent and the losses can’t be obscured anymore.

I am pleased to see BIS is getting exposure in NY Times (I have no relationship with the BIS, however since my years doing my MBA in the 90s, I have had a personal interest in Macro Economics and have been a great fan of BIS to say the least).

The issues raised by BIS are very real and are not tainted by any country’s political and interest groups’ spin. Needless to say, there are great Economic talent (Economists) in the US who have not sold their souls to Wall Street and politicians with colonial mindsets and practices, unfortonately they are silenced by the Wall Street fee generating machine…. As I have repeatedly pointed out in my postings in the past few weeks, the system is in danger of collapsing under its own weight and it is about to make a terrible mess. It looks as if in the capital markets similar to the political system, the “inmates have taken over running the asylum”!!!

Bank of America and others in its class are not banks anymore. They are animals of the 1900s that were recreated/resurrected by ignoring the operating guidelines of BIS since 1988 and revoking the Glass-Steagal Act.

As I have pointed out previously, the Banks’ Balance Sheets are no longer comprehensible to any analyst, including their own in house experts and the CFOs!!! I have a question for BAC management, and that if they would be kind enough to oblige and spoil us all with explaining their “working capital and liqudity” strength…

Today Fannie Mae and Freddie Mac announced that they have accpeted the “new” rules for “independant evaluation” of mortgages they would take on from now on, what a surprise….

I just looked at their balance sheet (FNM) and sounds like as of Dec 31/2007 they had Current Assets of $58 Billion and Current Liabilities of $242 Billion, a net working capital “deficit of $184 Billion”, an increase of $40 billion over their previous quarter (similar to the Banks, they shy away from tallying up their CA and CL, sounds like they even themselves are afraid to look into the Pandora’s box)!!!

The statement from BIS says that there is only the “perceptions of systemic risk” which leads one to believe that risk in the marketplace is only a perception and not reality. Which is exactly the type of thinking that got us into this conundrum. Big banks have been ignoring reality and taking stock in their wishful perceptions. The results of this type of backward thinking has permeated the financial markets for years.
When a client complains about his losses, I’ll just have to tell him it is only the perception of systemic risk that he should fear, not the reality of risk in the market place. What a bunch of hogwash.

My reading is that they are differentiating between “weak US Macroeconomic situation” and the side effect that it is generating which is the “perceived chances of global financial stress”.

Not all “non US” bank balance sheets are affected by the current write-downs-to-market as is being experienced by Citi, JPM, AIG etc., under the current market conditions. For example, Deutsche Bank AG recently announced that they have zero exposure to the subject securities, while UBS and Credit Swiss see substantial downside due to their misadventures in the Subprime and CDO markets.

One may argue that since some “non-US” banks and investors are on the hook, or are directly or indirectly affected by the SIV and CDO fiascos, their balance sheets are getting hit and it looks and it resembles as if their own economies (in the global markets in general) are going through a weak economic period and financial stress. The case for the “Northern Rock” in the UK is a prime example….

This is also evidenced by many companies in Dow Jones Industrials, suggesting that their international business is not slowing down, while they see weaknesses in demand in continental US.

Incidentally Citi reported recently that their international operations are on track to meet their annual objectives this year.

I read the remarks made by B. Bernanke and his deputy D. Kohn, and must say that I am pleased to see some genuine language, leadership and action plan to resolve the current situation and arrive at an “equitable” outcome between the lenders/banks and the borrowers/consumers.

The Fed is on track by creating liquidity and not repeating the 1929-1933 “Great Contraction” scenario where they moved in the opposite direction and reduced the money supply by 35%. I am also pleased with his tone addressing the lenders to arrive at a formula to write the “upside down” mortgages to market, this move is also encouraging. One solution will be to reevaluate the property, draw up a new mortgage based on the current market value, allow the borrower to take full capital loss for the equity and redopsit the tax return in the new mortgage as equity. The government will be well advised to push this line of thinking and even have an interim six months income tax filing so the system can get moving. Any future capital gain will be split between the lender and the borrower if and when a capital gain is realized. This would have a direct psychological impact on the consumers via equitable/fair treatment and would begin to boost the “consumer confidence” through the “newly found sense of wealth effect”….

The remarks made by D. Kohn, are also on target and suggest that the Fed is looking itself in the mirror and is fessing up to lack on supervision and poor risk definition, interpretation and treatment by the regulators and the senior management in the banks and the banking system as a whole. Here again the Fed needs to listen to BIS and start a plan to clean up the balance sheets of the banks asap, but in an orderly fashion.

I also read the recent comments made by various parties on Citigroup. I believe that they, along with other banks suffering from similar symptoms, need to cut their dividend to under $2 Billion immediately (this would save them $4-5 Billion/year) and issue warrants expiring 8-10 quarters out. This would raise additional 25-35 Billion dollars (issue cost would be minimal), would protect the current investors from dilution and have a fairly good upside potential as they work through the challenges on the balance sheet front. Reducing staff and other expenditures can also help ease the pain and deal with any unforeseen events. Finally, the Fed needs to put the breaks on introducing/implementing Basel II Accord and move towards reimplementing Glass-Steagal Act, or a derivation of, in the next couple of years.

To defend the US Currency and tame the inflation, the Fed needs to persuade the ECB, Japanese, British and Canadian Central Banks to support the dollar in the interim. It would be in the best interest of all the subject jurisdictions that the US Currency appreciates by 20-25 percent across the board, so an acceptable equilibrium is reached-till the US economy start sorting things out. This would have a direct impact on the price of oil and other commodities worldwide. Furthermore US, Japan and other nations that have strategic oil reserves need to enter the oil market as the prices rise to a certain threshold and moderate this key input cost by selling some reserves and beating the traders/speculators in their own game….

Final lesson from the current turmoil would be to build, in time, a healthy foreign currency reserve and create additional redundancies and safety mechanisms in the system to defend the dollar in future melt downs.

In the article “Step by step, Bush and Fed move on Mortgage Rescue” today, 5 March, by Edmund L Andrews and Vikas Bajaj, they discuss the effects of various policy options and their likely effect. They assign the “liberal” view to Dean Baker of the Center for Economic and Policy Research. Baker is apparently more concerned for a theoretical and controversial view of costs to “the taxpayer”, than relieving those in “default” with their payments. By “the taxpayer”, the poorest are by implication excluded, even if they do pay taxes: they certainly do contribute to the economy.

Whatever this “Center” researches into it is more like Chicago conservatism (US), than Conservatism(British) or Keynesianism. Baker shows in articles in The Guardian that he either is ignorant of Keynes most popular writings, or is in favor of “the deliberate intensification of unemployment”! It seems to be beyond Baker’s understanding that a slump will reduce the value of most people’s income far more than any supposed increase in tax rates in the future.

Baker is not alone in taking the same line as the British Labour Government of 1929-31 which put up unemployment from 10% to 20% in two years, attempting to balance the budget and keep to the “gold standard” at the same time.

David Leonhardt, in a very interesting and important article, Unemployed, and Skewing the Picture, refers to the crisis of 1873. This followed the triumph of Bismarck in the Franco-Prussian war of 1870. Bismarck demanded, and received, £200million pounds worth of gold in Reparations from the French, which virtually cleared out the Bank of England as well as Paris. Bismarck promptly went on the Gold Standard and Germany promptly went into slump, her own “cross of gold“, with repercussions across Europe. The US during the 19th century was highly dependent on liquidity from the Bank of England, so suffered from errors not all of her own making.

It might be worthwhile to sketch a solution to the subprime problem that does minimal or no damage to vulnerable borrowers, but penalizes wealthy rentiers who did not care to accurately assess the risk of their investment. The interesting thing about this solution is it is “market based” but involves the state as a player.

The government sets up a reconstruction finance corp to buy mortgage paper about to be foreclosed at market rates. Given the fall of housing prices this will amount to buying the property on the cheap. The government then renegotiates both the principal and interest on the loan using fixed rates only geared to the ability of the borrower to pay. Note that creditors in this scheme will be free to nenegotiate the terms of the agreement prior to this time and need not sell.

If the creditor chooses to foreclose then the bank is obliged to judicially put the property up for judicial sale a month after forecloseure and must have an offer for purchase after six months. If there is no offer, the state takes the property compensating the lenders at 1/2 the market rate if at all for the property. In any event, the lender must sell the property in a fixed period of time The government then renegotiates the terms of the loan with the borrowers including interest principle and either keeps the mortgage or sells it on the open market.

Only properties where the borrower has been shown to engage in fraud which was unknown by the original lender will be exempt from the scheme.
Nothing like this will be ever enacted in our give to the rich take from the poor society but a solution to the problem exists. Compared to the balance in fixing immigration this is easy.

As I emailed you I felt that Thornburg business model was flawed but I did not really give an explanation of why.

To my mind there are several reasons….

1. Their cost of money is higher than that of depositary institutions.
2. Often hedges do not work because of changes in capital markets – ironic because one of the reasons
of a hedge is to mitigate the effect of such changes.
3. In stressful times you must rely on competitors to keep the ship afloat. Usually not a good idea. Unspoken but true – competitor like to eliminate competition when possible
4. Borrowing short and lending long is much more risky than one may think. Financial markets are just too unpredictable.
5. Default triggers in credit instruments
6. The need for too much leverage to produce competitive equity returns.

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